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The R&D tax credit can provide valuable tax savings to businesses that invest in developing new products, improving existing products, creating software, developing manufacturing processes, or solving technological challenges. However, claiming the credit requires more than demonstrating that a company performs research.

Businesses must also establish that the expenses included in the credit calculation are actually connected to qualified research activities and are properly supported by documentation.

The case of Basim Shami v. Commissioner provides an important example of what can happen when a company has legitimate research activities but cannot adequately substantiate the wages it includes as qualified research expenses.

For businesses that include executive compensation in their R&D tax credit calculation, the case offers an especially important warning: executive involvement in innovation does not automatically make an executive's wages qualified research expenses.

For a detailed discussion of the case, read Basim Shami v. Commissioner: What It Means for Your R&D Tax Credit.

Understanding the R&D Tax Credit

The federal Research and Development Tax Credit, commonly called the R&D tax credit, is designed to encourage businesses to invest in qualified research.

Companies across many industries may potentially qualify, including manufacturers, engineering firms, software companies, technology businesses, chemical companies, consumer-product manufacturers, and other organizations conducting eligible research.

However, the existence of research within a company does not mean every employee's wages qualify.

Under Section 41, qualified research expenses can include certain wages paid for qualified research services. The applicable regulations distinguish between employees who directly perform qualified research and those whose activities are primarily management or general oversight.

This distinction became central to the Shami case.

What Happened in Basim Shami v. Commissioner?

The case involved Farouk Systems, Inc., a company involved in the development and sale of hair, skin, and nail products.

The company had an established research and development operation that included research personnel, chemists, laboratory technicians, and a vice president of research and development.

The IRS challenged certain R&D tax credit claims involving wages paid to two high-level executives, Farouk Shami and John McCall.

The taxpayers argued that substantial portions of the executives' compensation represented time spent performing qualified research activities.

The Tax Court ultimately concluded that the claimed executive wages did not qualify as research expenses because the taxpayers failed to adequately substantiate the executives' performance of qualified research services and the claimed wage allocations. The Fifth Circuit later affirmed the core wage-related ruling. 

Why Executive Wages Can Be Complicated

Executives can play an important role in product development and innovation.

A CEO may participate in product-development meetings, review prototypes, discuss technical problems, approve design alternatives, or work with engineers and scientists. A founder may have extensive technical knowledge and personally contribute to product development.

But involvement in a company's innovation strategy does not automatically mean every hour spent by an executive constitutes qualified research.

The key issue is what the executive actually did.

Activities involving direct participation in qualifying research or certain direct supervision or support of qualified researchers may potentially qualify. General management, business strategy, financial decision-making, product approval, and broad executive oversight generally require a different analysis.

This distinction is one of the most important lessons businesses can take from Shami.

Documentation Can Make or Break an R&D Tax Credit Claim

One of the biggest lessons from the case is the importance of R&D tax credit documentation.

A company may genuinely perform qualified research, but it still needs sufficient evidence to establish the connection between the research and the expenses being claimed.

In Shami, the taxpayers relied heavily on testimony concerning the executives' involvement in research. The court found the evidence insufficient to establish the claimed wage allocations.

This illustrates why relying exclusively on employee recollection can create problems.

Instead, businesses should develop documentation during the ordinary course of their operations.

Project records, laboratory notebooks, development reports, technical communications, meeting records, testing information, project-management systems, and other business records can help establish what an employee actually did.

Why Contemporaneous Records Are Important

Contemporaneous documentation means records created as the research activities occur rather than records reconstructed years later solely for purposes of supporting a tax claim.

For executive wages, this can be particularly important.

An executive may remember participating in product development, but a tax examination could occur long after the relevant research took place. Memories can become incomplete, and general statements about participation may not establish the specific qualified services performed.

Records created during the project can provide independent evidence.

For example, a development meeting record might identify an executive's participation in evaluating technical alternatives. A project-management record might show involvement in resolving a technical uncertainty. An engineering communication could demonstrate that an executive directly participated in a qualifying research activity.

These types of records can create a stronger evidentiary foundation for an R&D tax credit study.

The Difference Between Research and Management

Businesses should carefully distinguish between research activities and ordinary management activities.

An executive who establishes a company's overall product strategy may be deeply involved in innovation but may not necessarily be performing qualified research.

Similarly, approving a research budget or reviewing a completed research project is different from directly performing or supervising qualifying research.

This does not mean executive wages can never qualify.

Rather, the company needs to identify the portion of the executive's work that actually meets the requirements for qualified research services and support that allocation with appropriate evidence.

Can the Cohan Rule Save an Unsupported Claim?

Another important issue arising from Shami involves the Cohan rule.

The Cohan rule can sometimes allow courts to estimate expenses when a taxpayer establishes that an expense occurred but cannot establish its exact amount, provided there is a reasonable evidentiary basis for the estimate.

However, taxpayers should not view Cohan as a substitute for proper documentation.

In Shami, the court did not accept the taxpayers' request for an estimate of the executives' qualifying research wages because the evidence did not provide a sufficient basis for making a reasonable determination.

The lesson is straightforward: businesses should not build their R&D tax credit strategy around the expectation that a court will simply estimate unsupported expenses.

Executive Participation May Still Qualify When Properly Supported

The Shami decision should not be interpreted as meaning that executive wages can never be included in an R&D tax credit claim.

Executives can potentially perform qualified services.

For example, a technically trained executive might directly participate in developing a new product, conduct experiments, evaluate technical alternatives, or directly supervise researchers working through a qualified research process.

The important consideration is whether the activities satisfy the applicable requirements and whether the company can substantiate them.

Therefore, businesses should evaluate executive activities based on actual work rather than automatically including or excluding executive compensation.

How Companies Can Strengthen Their R&D Documentation

Businesses claiming the research and development tax credit should consider implementing documentation procedures that capture research activity throughout the year.

Technical employees can document project objectives, technological uncertainties, alternatives considered, testing performed, and conclusions reached. Finance teams can track employee wages and other potentially qualified expenses.

For executives, the company can maintain project records that identify their specific involvement in qualifying research activities.

This does not necessarily require employees to create complicated paperwork for every activity. The goal is to create a reasonable and consistent record that connects the employee's work to the qualifying research.

Why This Matters Across Multiple Industries

Although the Shami case involved a consumer-products company, the underlying lesson applies broadly.

Manufacturing companies may have executives involved in new product development. Engineering firms may have senior professionals supervising technical projects. Software companies may have founders participating directly in software development. Food and beverage companies may have executives involved in formulation and testing.

In each situation, the same question applies:

What did the employee actually do, and can the company prove it?

That question should be considered before including significant executive wages in an R&D tax credit calculation.

Preparing for an IRS R&D Tax Credit Examination

Businesses should assume that documentation may eventually be reviewed.

A strong R&D tax credit study should therefore explain the connection between the company's research activities, employees, business components, and qualified research expenses.

If executive wages represent a significant percentage of the company's claimed wage QREs, the company should have particularly strong support for those allocations.

A well-prepared claim can make it easier to respond to questions because the underlying evidence is already organized.

Final Thoughts

The Basim Shami v. Commissioner case provides a valuable lesson for companies claiming the R&D tax credit.

Having genuine research activities is not enough. Businesses must also establish which employees performed qualified research services and provide credible evidence supporting the wages included in the credit calculation.

Executive participation in product development or innovation can potentially qualify, but general management and strategic oversight should not automatically be treated as qualified research.

The strongest approach is to build documentation while the research is taking place. Project records, technical documentation, employee information, and other contemporaneous business records can help establish a credible connection between the employee's work and the qualified research activity.

Businesses that perform research and development under government or commercial contracts often assume that receiving payments from a customer automatically prevents them from claiming the R&D tax credit. That assumption can be costly.

The federal R&D tax credit is intended to encourage businesses to invest in qualified research activities. However, Section 41 contains specific rules concerning research that is considered “funded.” Understanding these rules is particularly important for government contractors, aerospace companies, defense manufacturers, engineering firms, software developers, and other businesses performing technical work for customers.

The Fairchild Industries case provides an important foundation for understanding how financial risk, contract terms, payment conditions, and rights in research can affect whether contract research qualifies for the R&D tax credit.

For a detailed explanation of the case, see Funded Research vs. R&D Tax Credits: The Fairchild Case Explained.

What Is Funded Research?

Under the federal R&D tax credit rules, certain research expenses may be excluded when the research is considered funded by another party. The basic concept is that the tax incentive is intended to reward taxpayers that bear the economic risk associated with conducting qualified research.

This creates an important distinction for companies working under contracts.

A company may receive payments from a customer while still bearing meaningful financial risk if the customer does not ultimately have to pay for unsuccessful work or if the contractor must repay certain amounts when contractual requirements are not satisfied.

Therefore, the existence of customer payments alone does not necessarily answer the question of whether research is funded.

The specific terms of the contract and the economic relationship between the parties need to be examined.

The Fairchild Industries Case

The Fairchild case involved an aerospace company performing work for the U.S. Air Force under a fixed-price incentive contract relating to the development and construction of the T-46A aircraft.

The IRS challenged Fairchild's treatment of certain research expenses and argued that a portion of the research was funded because the government had provided progress payments during the project.

The dispute ultimately reached the U.S. Court of Appeals for the Federal Circuit. The court examined the structure of the contract and the financial risk Fairchild actually faced during the research and development process. The court concluded that the lower court had interpreted the funded-research provisions incorrectly. 

The case became important because it demonstrated that simply receiving payments from a customer does not automatically mean that the underlying research is “funded” for purposes of the R&D credit.

Financial Risk Is a Critical Consideration

One of the most important lessons from Fairchild is the role of financial risk.

When evaluating whether research is funded, businesses should examine who bears the risk if the research does not produce an acceptable result.

For example, suppose a contractor agrees to develop a new technical system under a fixed-price contract. The customer may make progress payments during development, but the contractor could still face significant financial exposure if the final product fails contractual acceptance requirements.

In that situation, the contractor may have substantial economic risk associated with the research.

This is different from an arrangement where a customer is obligated to reimburse the contractor for research expenses regardless of the outcome.

The difference can be significant when determining whether research expenses are eligible for the federal R&D tax credit.

Why Contract Language Matters

Companies performing contract research should never overlook the importance of their agreements.

A contract can contain provisions that help demonstrate who bears financial risk, who owns or can use the resulting research, what happens when a project fails, and whether payments are contingent on successful performance.

These provisions can become important evidence when an R&D tax credit claim is reviewed.

Government contractors should therefore preserve complete copies of contracts, amendments, statements of work, technical specifications, acceptance requirements, change orders, and related correspondence.

These documents can provide valuable support for an R&D tax credit study because they help establish the commercial and financial circumstances surrounding the research.

Progress Payments Do Not Automatically Eliminate R&D Credit Eligibility

Another important lesson from Fairchild is that progress payments should not automatically be treated as proof that research is funded.

Government and commercial contracts frequently involve milestone payments, advance payments, progress payments, or other forms of periodic compensation.

The existence of these payments does not necessarily establish that the customer bears all of the economic risk.

Instead, businesses should evaluate the entire contractual arrangement.

Questions may include whether the contractor must satisfy acceptance requirements, whether payments can be withheld, whether amounts must be repaid, whether the contractor absorbs cost overruns, and what happens when research does not produce the expected result.

A detailed contract review can therefore be essential before excluding potentially qualifying research expenses.

Retained Rights Can Also Matter

Financial risk is not the only consideration in a funded research analysis.

The rights that a contractor retains in the research can also be relevant. Businesses should examine whether they retain meaningful rights to use the technology, processes, designs, methods, or other research results they develop.

This issue is particularly important for engineering, aerospace, defense, software, and manufacturing companies that perform research for customers.

A contract that transfers or restricts rights may create a different tax analysis from one that allows the contractor to retain substantial rights to the underlying research.

For this reason, R&D tax credit compliance should include a review of relevant intellectual property and contractual provisions rather than focusing only on payroll and expense calculations.

Government Contractors Should Review Each Contract Separately

Businesses sometimes make the mistake of applying the same R&D tax credit conclusion to every customer contract.

That can create unnecessary risk.

Two contracts may involve similar technical work but contain completely different payment terms, acceptance requirements, financial-risk provisions, and intellectual-property clauses.

One project may create substantial financial risk for the contractor, while another may provide guaranteed reimbursement regardless of the research outcome.

Therefore, the funded-research analysis should be performed at the appropriate contract and project level.

This contract-by-contract approach can help businesses identify potentially qualifying research that might otherwise be incorrectly excluded.

Documentation Is Essential for an Audit-Ready R&D Claim

A strong R&D tax credit claim should be supported by more than a final calculation.

Businesses should maintain documentation showing what research was performed, which employees participated, what technical uncertainties existed, how experimentation was conducted, and how qualified research expenses were determined.

For contract research, the supporting documentation should also demonstrate the contractual relationship between the parties.

Contracts, project records, engineering documentation, testing results, employee records, invoices, payment information, and project communications can all contribute to a more complete record.

The purpose is to create a clear connection between the research activity, the financial risk, the contract terms, and the expenses included in the credit calculation.

Avoid Automatically Excluding Contract Research

Because of the complexity surrounding funded research, some businesses may take an overly conservative approach and exclude all contract-related research from their R&D tax credit calculations.

That can result in missed tax opportunities.

A company that performs qualified research under a government or commercial contract should evaluate the actual terms of the arrangement before deciding that the research is ineligible.

The Fairchild decision demonstrates why the analysis should focus on the substance of the contractual relationship rather than simply asking whether another party provided payments.

A careful review may reveal that the contractor retained meaningful financial risk and therefore may have a stronger basis for claiming the credit.

How Businesses Can Strengthen Their R&D Tax Credit Strategy

The best approach is to evaluate potential R&D activities and contract arrangements before the tax return is prepared.

Technical teams can identify the research activities and uncertainties involved, while finance teams can track wages and other potentially qualified expenses. Legal or contract teams can review payment terms, acceptance requirements, intellectual-property provisions, and financial-risk clauses.

Bringing these perspectives together can produce a more complete R&D tax credit analysis.

Technology can also make the process more efficient by organizing project information and supporting documentation in a centralized system.

The objective should be to identify the maximum defensible credit while maintaining records that explain exactly why the claimed activities and expenses qualify.

Final Thoughts

The Fairchild Industries case remains an important lesson for companies performing research under government and commercial contracts.

The fact that a business receives payments from a customer does not automatically mean that its research is funded for purposes of the R&D tax credit. The more important questions involve who bears the financial risk, what the contract requires, what happens if the research fails, and what rights the contractor retains in the research.

For government contractors, aerospace companies, defense businesses, engineering firms, manufacturers, and technology companies, these issues can have a significant impact on the availability of valuable R&D tax incentives.

Businesses should therefore review contracts carefully, maintain strong documentation, and evaluate each research arrangement based on its actual terms.

The Research and Development (R&D) Tax Credit has long been one of the most valuable federal incentives for businesses investing in innovation. Companies that develop new technologies, improve manufacturing processes, create proprietary software, or solve complex engineering challenges may qualify for significant tax savings through this program. However, qualifying for the credit requires more than simply performing innovative work.

Recent court decisions have reinforced an important reality: the wording of your contracts can determine whether your research activities qualify for the R&D Tax Credit. One of the most significant examples is Geosyntec Consultants, Inc. v. United States, a case that highlighted how customer agreements and contract terms influence tax credit eligibility.

For engineering firms, software companies, manufacturers, and other innovation-driven businesses, the case serves as an important reminder that legal agreements deserve as much attention as technical documentation. Businesses that fail to review contract language carefully may unintentionally lose valuable tax incentives despite investing heavily in research and development.

Understanding the R&D Tax Credit

The federal R&D Tax Credit was introduced to encourage businesses to invest in technological innovation. Companies can claim credits for qualified research expenses, including employee wages, supplies, and certain contractor costs incurred while developing or improving products, software, techniques, formulas, or manufacturing processes.

The credit is available across a wide range of industries, including engineering, manufacturing, software development, architecture, biotechnology, aerospace, construction, and advanced technology. Contrary to common misconceptions, businesses do not need laboratories or scientific breakthroughs to qualify. Incremental improvements and practical innovation often satisfy the requirements when they involve technical uncertainty and a process of experimentation.

However, qualifying research must also satisfy legal requirements regarding funding arrangements and ownership rights—issues that were central to the Geosyntec case.

What Was the Geosyntec Case About?

The Geosyntec v. United States case focused on whether research activities performed under customer contracts qualified for the federal R&D Tax Credit. While the company performed highly technical engineering work involving environmental consulting and innovative problem-solving, the court examined more than just the technical activities.

A key issue was whether the research was considered funded research under Internal Revenue Code Section 41. If research is fully funded by a customer, the company performing the work may not be eligible to claim the R&D Tax Credit.

The court carefully reviewed the contractual agreements to determine who bore the financial risk associated with the projects and who retained substantial rights to the research results. These contractual details became just as important as the engineering work itself.

The case demonstrated that businesses cannot evaluate R&D tax credit eligibility by looking only at technical innovation. Contract language must also be carefully analyzed.

Why Contract Language Plays Such an Important Role

Many businesses view contracts primarily as legal documents governing project scope, pricing, and delivery schedules. From a tax perspective, however, contracts often determine whether research expenses qualify for valuable federal incentives.

The IRS evaluates customer agreements to understand how research projects are funded. If payment is guaranteed regardless of the project's technical success, the research may be considered funded by the customer. Likewise, if the customer receives exclusive ownership of all research outcomes, the company performing the work may have limited rights to the resulting technology.

Neither of these factors automatically disqualifies a claim, but together they influence whether research satisfies the requirements for claiming the federal R&D Tax Credit.

This is why contract review has become an essential part of modern R&D tax credit planning.

Lessons Businesses Can Learn from Geosyntec

The Geosyntec decision offers valuable lessons for businesses across multiple industries.

First, companies should never assume that technical innovation alone guarantees eligibility. Even groundbreaking engineering or software development projects may fail to qualify if contract terms indicate the research was fully funded by the customer.

Second, contract review should occur before projects begin rather than after tax returns are prepared. Evaluating agreements early allows businesses to identify provisions that may affect future tax credit claims and make informed decisions before signing.

Third, documentation remains essential. Businesses should maintain contemporaneous records demonstrating technical uncertainty, experimentation, project objectives, employee involvement, and qualified research expenses. Strong documentation complements favorable contract language and strengthens audit readiness.

Finally, businesses should recognize that tax credit planning is not solely an accounting function. Engineering teams, legal departments, finance professionals, and tax specialists all play important roles in protecting valuable research incentives.

The Importance of Audit-Ready Documentation

As IRS scrutiny of R&D tax credit claims continues to increase, businesses must maintain organized documentation throughout the research process. Waiting until tax season to gather information often results in incomplete records and weaker claims.

Effective documentation should include project descriptions, engineering reports, software development records, testing documentation, payroll information, technical meeting notes, and financial records connecting qualified expenses to individual research projects.

These records help demonstrate that research activities satisfy IRS requirements while supporting the calculations included in the tax credit study.

When combined with well-structured contracts, comprehensive documentation significantly improves the defensibility of an R&D tax credit claim.

How Technology Is Transforming R&D Tax Credit Compliance

Preparing R&D tax credit studies manually can be time-consuming, especially for organizations managing multiple projects across several departments. Modern AI-powered platforms simplify this process by organizing documentation, identifying qualified activities, connecting expenses to projects, and generating structured reports.

Technology allows businesses to improve consistency, reduce administrative effort, and create audit-ready documentation more efficiently than traditional manual processes. While automation cannot replace professional judgment, it enhances the accuracy and organization of the information supporting every claim.

This combination of technology and expertise has become increasingly valuable as IRS expectations continue to evolve.

Why Businesses Choose TaxDrone

TaxDrone combines artificial intelligence with experienced tax professionals to simplify every stage of the R&D tax credit process. The platform helps businesses identify qualified research activities, calculate Qualified Research Expenses (QREs), organize technical documentation, and prepare comprehensive tax credit studies that align with current IRS requirements.

Unlike generic tax preparation services, TaxDrone focuses specifically on research tax incentives and understands the importance of both technical documentation and contract analysis. This specialized approach enables businesses to maximize legitimate tax savings while reducing compliance risks.

Whether your organization operates in engineering, software development, manufacturing, biotechnology, or another innovation-focused industry, TaxDrone provides the expertise needed to navigate today's increasingly complex R&D tax credit landscape.

Learn more about TaxDrone's R&D Tax Credit solutions here:

Preparing for Future Success

The Geosyntec case demonstrates that successful R&D tax credit claims require more than innovation. Businesses must understand how customer agreements, funding arrangements, intellectual property rights, and documentation work together to determine eligibility.

By reviewing contracts early, maintaining detailed project records, and seeking guidance from experienced specialists, organizations can strengthen their tax credit claims while reducing audit risk.

As innovation continues to drive business growth, protecting the tax incentives associated with that innovation should become an integral part of every company's long-term financial strategy.

Conclusion

The Geosyntec v. United States decision serves as a powerful reminder that contract language can have a significant impact on R&D tax credit eligibility. Even companies performing highly technical and innovative work may lose valuable tax incentives if customer agreements indicate the research was funded or if contractual rights are not properly understood.

Businesses that combine strong technical documentation with careful contract analysis are far better positioned to maximize available tax credits while remaining compliant with IRS requirements.

Businesses across many industries invest in developing new products, improving processes, testing materials, creating software, and solving technical challenges. These activities may potentially qualify for the federal R&D tax credit, but simply performing innovative or technically complex work does not guarantee eligibility.

One of the most important lessons businesses can learn from tax court decisions is that an R&D tax credit claim needs to be supported by evidence showing what the specific company actually did.

The Leon Max v. Commissioner case provides a particularly useful example. It demonstrates why a generic R&D tax credit study based on industry assumptions may not be enough to establish that a company's activities satisfy the requirements of Section 41.

What Is the R&D Tax Credit?

The federal Research and Development Tax Credit is designed to encourage businesses to invest in qualified research activities.

Companies in many industries may have potentially qualifying activities, including:

Manufacturing

Software development

Engineering

Technology

Automotive

Aerospace

Electronics

Chemicals

Product development

Apparel and textiles

However, the industry a company operates in does not automatically determine whether its activities qualify.

The focus is on the actual research performed, the technical challenges involved, the experimentation conducted, and the expenses associated with qualifying activities.

The Leon Max Case: An Important R&D Tax Credit Lesson

Leon Max, Inc. operated a large apparel business and used a structured process to develop garments from initial concepts through production.

The company claimed substantial research credits for tax years 2011 and 2012. A consulting firm later evaluated the company's design activities and used a sample of garments to support the credit claim.

The Tax Court ultimately disallowed the claimed research credits.

One of the major issues was the reliance on a generalized study rather than sufficient company-specific evidence demonstrating that the company's actual activities met the requirements for qualified research.

The case provides an important message for businesses considering an R&D tax credit study:

A generic description of what companies in an industry typically do is not necessarily evidence of what your company actually did.

Why Company-Specific Evidence Matters

A strong R&D tax credit documentation process should tell the story of the company's own research.

For example, rather than simply stating that apparel companies perform testing, a business should be able to demonstrate:

Which products were being developed

What technical problems were encountered

What alternatives were considered

What testing was performed

What changes were made

Which employees participated

What expenses were associated with the activities

This level of detail can help establish a connection between the company's actual work and the requirements of Section 41.

Understanding the Four-Part Test

Businesses evaluating R&D tax credit eligibility should understand the four-part test that applies to qualified research.

Generally, the research must relate to developing or improving a business component and involve an effort to eliminate uncertainty.

It must also rely on principles of physical or biological science, engineering, or computer science and involve a process of experimentation.

Meeting one element does not automatically establish eligibility.

A project can involve extensive testing and still fail to qualify if it does not satisfy the other requirements.

Technical Uncertainty Is Important

One important concept is technical uncertainty.

A business may encounter a difficult problem, but difficulty alone does not necessarily establish qualified research.

The company should be attempting to determine whether a particular capability can be achieved, which methodology should be used, or what design will work.

For example, a manufacturer may not know which material formulation will produce the required performance characteristics. Engineers may develop several alternatives and test them to determine which approach works best.

That type of structured technical investigation may provide stronger evidence than routine work based on established knowledge.

The Process of Experimentation

Another important element is the process of experimentation.

This generally involves evaluating alternatives and using testing or analysis to determine the most appropriate solution to a technical problem.

A company's documentation might show that its team:

Identified a technical challenge.

Considered multiple possible solutions.

Developed prototypes or alternatives.

Conducted testing.

Evaluated the results.

Modified the design or process.

Selected an approach based on the results.

Keeping records of this process can make it easier to explain how the research developed.

Why Generic Industry Studies Can Be Risky

A broad industry study might establish that companies within a particular industry commonly perform activities involving testing, design, engineering, or experimentation.

But that does not necessarily prove that a particular company performed qualifying research.

For example, saying that manufacturers generally test new materials does not demonstrate that a specific manufacturer conducted qualified research on a particular product.

Likewise, stating that software companies experiment with different technologies does not establish that a specific software project involved the required technical uncertainty and experimentation.

The stronger approach is to document the company's own projects, employees, technical challenges, and results.

Expert Witnesses Need Company-Specific Knowledge

The Leon Max case also illustrates why expert testimony should be based on verified facts.

An expert's opinion is more persuasive when the expert understands the company's actual operations and can connect the technical analysis to specific projects and activities.

An expert who relies heavily on a generalized report without independently verifying the underlying facts can face credibility problems.

Businesses should therefore ensure that their supporting experts and consultants have access to reliable project information and understand the specific activities being evaluated.

Qualified Research Expenses Need Supporting Evidence

The technical side of an R&D tax credit claim is only one component.

Businesses must also support their qualified research expenses (QREs).

Potentially relevant expenses can include certain employee wages, supplies, and contract research expenses, depending on the circumstances and applicable rules.

A company should be able to connect these expenses to the qualifying research activities.

For example, if an engineering employee spent part of the year working on qualifying product development and the rest performing routine production support, the business should have a reasonable basis for determining which portion of the employee's compensation relates to qualifying research.

Contemporaneous Documentation Can Strengthen a Claim

Documentation created during the research process can be particularly useful.

Companies can maintain:

Project descriptions

Technical notes

Design documents

Testing records

Prototype information

Employee records

Payroll data

Project management records

Research correspondence

Invoices and purchase records

These records can help establish what happened during the project instead of relying on recollections years later.

How Businesses Can Build a Stronger R&D Tax Credit Study

Businesses preparing an R&D tax credit study can take several practical steps.

Identify Specific Business Components

Start by identifying the products, processes, software, or other business components being developed or improved.

Document Technical Challenges

Record the technical uncertainties the team faced and why existing knowledge was insufficient.

Capture the Experimentation Process

Document alternatives considered, prototypes created, tests performed, and conclusions reached.

Identify the People Involved

Record which employees and contractors contributed to qualifying research.

Connect Expenses to Activities

Maintain financial records that demonstrate how wages, supplies, and other potentially eligible expenses relate to the research.

Review the Evidence Before Filing

Before claiming the credit, evaluate whether the documentation supports the specific activities and expenses included in the calculation.

Why Audit-Ready Documentation Matters

An R&D tax credit audit can require a business to explain why its activities qualify and how the credit was calculated.

A generic industry report may not adequately answer those questions.

A company-specific documentation system can provide a much stronger foundation because it demonstrates what the business actually did.

For a deeper explanation of the Leon Max case and why generalized R&D studies can fail to establish eligibility, read this Leon Max case and R&D tax credit guide.

Final Thoughts

The R&D tax credit can provide significant benefits to businesses that genuinely perform qualified research. However, a successful claim should be based on evidence rather than assumptions about what an industry typically does.

The Leon Max case demonstrates why company-specific evidence, technical documentation, employee information, project records, and qualified expense support are so important.

Businesses should focus on telling the story of their own research: what problem they faced, what uncertainty existed, what alternatives they considered, what experimentation they performed, and what results they achieved.

The federal R&D tax credit can be a valuable incentive for businesses that invest in developing new products, improving processes, creating software, or solving technical challenges. However, claiming the credit is not simply a matter of identifying expenses and submitting an amended tax return.

Businesses need to establish that their activities qualify, that the expenses are properly connected to qualified research, and that their calculations can be supported with reliable documentation.

The United States v. Quebe case provides an important example of what can happen when an R&D tax credit claim does not withstand IRS scrutiny. The case highlights several issues that businesses should understand before claiming research and development tax incentives.

What Is the R&D Tax Credit?

The Research and Development Tax Credit is a federal tax incentive intended to encourage businesses to invest in qualified research activities.

Potentially qualifying activities can occur across numerous industries, including:

Manufacturing

Engineering

Software development

Construction

Architecture

Electronics

Aerospace

Automotive

Technology

However, working in a technical industry does not automatically make every activity eligible.

The actual work performed must be evaluated against the applicable requirements for qualified research.

Understanding R&D Tax Credit Eligibility

One of the most important steps in preparing an R&D credit claim is determining whether the underlying activities actually qualify.

The R&D tax credit eligibility analysis generally involves examining whether a business component is being developed or improved and whether the research process involves the required technical uncertainty and experimentation.

For example, developing a new product may involve evaluating different technical approaches to determine which design will work best.

On the other hand, simply installing a product according to plans and specifications created by another party may not constitute qualified research.

This distinction is particularly important for contractors, manufacturers, engineering businesses, and other companies that perform technically sophisticated work.

The Four-Part Test Matters

Businesses evaluating qualified research should understand the basic elements of the four-part test.

The research generally needs to:

Relate to the development or improvement of a business component.

Seek to eliminate uncertainty regarding capability, methodology, or appropriate design.

Rely on principles of physical or biological science, engineering, or computer science.

Involve a process of experimentation.

Meeting only one or two of these elements is not enough.

A project may involve advanced equipment or highly skilled employees but still fail to meet the applicable requirements if it does not satisfy the full test.

Why Documentation Is Essential

One of the most important lessons from the Quebe case is the importance of R&D tax credit documentation.

Businesses should be able to demonstrate what research activities were performed, who performed them, what technical challenges existed, and how the claimed expenses relate to the qualifying work.

Useful records may include:

Project documentation

Engineering notes

Technical reports

Design records

Testing documentation

Employee time records

Payroll records

Project logs

Invoices

Contracts

Research correspondence

Creating these records while the work is being performed is generally much more useful than attempting to reconstruct the history years later.

Contemporaneous Records Can Strengthen a Claim

A business may remember that a particular project involved technical experimentation, but memory alone is not a strong substitute for contemporaneous documentation.

Records created during the research process can help demonstrate what actually happened.

For example, project notes might describe a technical problem, alternatives considered, testing performed, results obtained, and modifications made to the design.

Employee records can also help establish who participated in the research and how their time was allocated.

This creates a stronger connection between the technical activities and the qualified research expenses claimed.

Not Every Engineering Activity Qualifies

A common misconception is that every activity performed by engineers, developers, or technical employees automatically qualifies for the R&D tax credit.

That is not the case.

An employee's job title does not determine whether an activity is qualified research.

The specific work performed is what matters.

For instance, an engineer may spend part of their time developing an experimental product and another part of their time performing routine production support. Those activities should not necessarily be treated identically for purposes of the credit.

Businesses should evaluate activities at the project or activity level rather than applying broad assumptions to entire departments.

Statistical Sampling Requires Careful Methodology

For some businesses, reviewing every individual employee or transaction may be challenging, particularly when there are thousands of records.

Statistical sampling can potentially be useful when calculating qualified research expenses, but the methodology needs to be appropriately structured.

A sampling approach should be connected to the underlying business components and supported by a defensible methodology.

Businesses should not simply select a convenient percentage and apply it to their expenses.

A poorly designed sampling approach can undermine the credibility of the entire credit calculation.

An IRS Refund Does Not Automatically End the Matter

One of the most important lessons from the Quebe case is that receiving an IRS refund does not necessarily mean that the underlying R&D tax credit claim can never be challenged.

Businesses should therefore treat the initial filing as the beginning of their documentation responsibility rather than the end.

If the IRS later questions a claim, the company may need to demonstrate why the activities qualified and how the credit amount was calculated.

This is why R&D tax credit compliance should be built into the claim process from the beginning.

Common R&D Tax Credit Mistakes

Businesses can increase their risk when they:

Claim Routine Activities as Research

Routine installation, maintenance, or production work should not automatically be classified as qualified research.

Use Generic Documentation

A general statement that a company “performs R&D” does not adequately describe the specific research activities performed.

Reconstruct Records Years Later

Recreating technical records after an IRS inquiry can be much more difficult than maintaining documentation during the project.

Apply Unsupported Estimates

Expenses and employee time allocations should be based on a reasonable and supportable methodology.

Treat Every Technical Employee as a Qualified Researcher

Job titles alone do not establish that an employee's activities qualify.

How Businesses Can Prepare a Stronger R&D Claim

Companies can take several practical steps to improve their R&D tax credit compliance process.

First, identify potentially qualifying projects during the year.

Second, document the technical uncertainties and experimentation involved in those projects.

Third, identify the employees who participated in qualifying activities and maintain appropriate records of their involvement.

Fourth, connect the research activities with the associated qualified expenses.

Finally, maintain the documentation supporting the credit calculation and methodology.

For a detailed discussion of the Quebe case and the lessons it provides for businesses claiming R&D credits, read this Quebe case warning for R&D tax credits.

Why Businesses Should Review Their Existing Claims

Companies that have already claimed an R&D tax credit can also benefit from reviewing their documentation and methodology.

A review can help identify whether the business has sufficient records to support its research activities, whether its expenses are properly connected to qualifying projects, and whether its calculation methodology is defensible.

This is especially valuable for companies with complex operations, large numbers of employees, multiple locations, or substantial research expenditures.

The goal is not simply to maximize the credit. The goal is to claim the credit accurately and maintain sufficient support for the position.

Final Thoughts

The R&D tax credit can provide meaningful tax benefits for businesses that genuinely perform qualified research. However, businesses should not treat the credit as a simple calculation exercise.

The Quebe case demonstrates why eligibility, documentation, expense tracking, and calculation methodology all matter.

Companies should evaluate their activities against the applicable requirements, maintain contemporaneous records, connect expenses to specific research activities, and use appropriate methodologies when calculating qualified research expenses.

The federal Research and Development (R&D) Tax Credit continues to provide valuable tax savings for businesses investing in innovation. Companies involved in software development, manufacturing, engineering, biotechnology, construction, and product design can often claim substantial credits for qualified research activities. However, recent IRS enforcement trends and ongoing Tax Court cases demonstrate that innovation alone is no longer enough to secure these benefits.

Today's tax environment places greater emphasis on how businesses document their qualified research activities than ever before. Companies that rely on estimates, retrospective interviews, or incomplete records may find themselves defending otherwise legitimate R&D tax credit claims during an IRS examination.

For CFOs, controllers, and tax professionals, the message is clear: documentation should be treated as an ongoing compliance process rather than a year-end tax exercise.

The Growing Importance of R&D Tax Credit Substantiation

The IRS requires taxpayers claiming the R&D Tax Credit under Internal Revenue Code Section 41 to prove that their research activities satisfy the statutory requirements. This includes demonstrating:

A permitted business purpose

Technical uncertainty

A process of experimentation

Qualified research expenses directly connected to eligible activities

While many organizations focus on identifying qualified projects, the supporting documentation often receives far less attention until after the tax year has ended. Unfortunately, reconstructing records months later is significantly more difficult than maintaining them throughout the research process.

Recent Tax Court cases indicate that contemporaneous documentation is becoming increasingly important when evaluating the validity of R&D tax credit claims. Courts have shown a preference for records created while research is taking place rather than relying primarily on employee recollections gathered long after the work has been completed.

Common Documentation Mistakes Businesses Make

Many companies unintentionally weaken their R&D tax credit claims by relying on documentation methods that are difficult to defend.

Some of the most common issues include:

Estimating employee time months after projects are completed.

Using interviews as the primary source of documentation.

Failing to connect wages and supply costs to specific research projects.

Maintaining incomplete engineering or technical records.

Keeping inconsistent project documentation across departments.

Although these approaches may simplify tax preparation initially, they can create significant challenges if the IRS requests supporting evidence.

Why Real-Time Documentation Matters

Maintaining documentation throughout the year provides a much stronger foundation for an R&D tax credit claim than attempting to recreate information after filing a return.

Examples of valuable contemporaneous documentation include:

Project plans

Engineering notebooks

Technical design documents

Testing results

Version control records

Project management data

Employee time tracking

Prototype development records

Meeting notes discussing technical uncertainty

These records help establish that research activities occurred as described while also linking qualified expenses to specific business components.

Technology Is Changing R&D Tax Credit Compliance

Traditional R&D tax studies frequently rely on spreadsheets, interviews, and manual documentation reviews performed after year-end. While these methods remain common, many businesses are adopting technology-driven approaches that improve both efficiency and compliance.

Modern documentation platforms can help organizations:

Capture research activities as they occur.

Organize project-level evidence automatically.

Connect technical work with financial records.

Improve wage allocation accuracy.

Produce audit-ready documentation.

Reduce administrative effort.

Rather than replacing professional tax advice, technology helps create stronger documentation that supports more defensible tax credit claims.

What Finance Leaders Should Do Now

CFOs and finance teams should review their documentation practices before preparing their next R&D tax credit study.

Recommended best practices include:

Identify qualified research projects early in the tax year.

Track employee participation continuously.

Preserve technical records throughout each project.

Document supply costs at the project level.

Review supporting documentation before filing tax returns.

Coordinate engineering, accounting, and tax teams throughout the year.

Taking these proactive steps reduces compliance risk while improving confidence in the accuracy of claimed credits.

Learn How Recent Tax Court Cases Are Raising Documentation Standards

Recent Tax Court proceedings involving R&D tax credit substantiation illustrate how documentation practices can directly influence the outcome of an IRS examination. The cases highlight why contemporaneous records, expense traceability, and project-level documentation are becoming increasingly important for defending qualified research expenses.

To better understand these evolving expectations, read When Documentation Fails: What Two Active Tax Court Cases Tell CFOs About R&D Credit Substantiation. The article explains how recent cases involving Kyocera and George emphasize the importance of real-time documentation and provides practical insights for building stronger, audit-ready R&D tax credit claims.

Conclusion

The R&D Tax Credit remains one of the most valuable incentives available to innovative businesses, but the documentation standards surrounding these claims continue to evolve. Companies that rely on retrospective estimates or incomplete records may face unnecessary challenges during IRS examinations.

For companies claiming the Research & Development (R&D) Tax Credit under IRC Section 41, documentation is more than a compliance requirement—it is the foundation of a defensible claim. While many businesses believe that prior IRS settlements or negotiated agreements permanently establish their tax position, recent court decisions demonstrate otherwise.

The Audio-Technica case serves as an important reminder that settlement agreements only resolve the specific issues and tax years identified within those documents. Unless the language clearly establishes broader rights, taxpayers cannot assume those agreements automatically protect future R&D tax credit claims. Businesses must continue maintaining accurate records and supporting documentation for every claim they file.

Why Settlement Language Matters

Settlement agreements are legal contracts. Courts interpret them according to the exact wording used, not the intentions that either party may have assumed during negotiations.

If an agreement states that it resolves a dispute for a particular tax year, it generally cannot be relied upon to govern future years unless that intention is explicitly documented. The Audio-Technica litigation highlighted how relying on prior settlement terms without carefully reviewing their scope can create unexpected challenges during later IRS examinations.

Common Misunderstandings

Many companies incorrectly believe:

A previous IRS settlement guarantees future R&D credit treatment.

Once a methodology has been accepted, it will never be questioned again.

Prior audit success automatically validates future filings.

Settlement documents replace the need for ongoing documentation.

In reality, every tax year stands on its own. Businesses must continue demonstrating that they satisfy the Section 41 requirements and maintain documentation supporting each year's qualified research activities.

The Importance of Clear Documentation

Strong documentation should include:

Project descriptions

Technical uncertainties addressed

Process of experimentation

Employee time allocation

Supply and contract research expenses

Engineering records

Testing documentation

Financial support for Qualified Research Expenses (QREs)

The IRS increasingly expects contemporaneous documentation rather than retrospective estimates prepared years later. Recent court decisions consistently reinforce this expectation.

What Finance Leaders Should Do

CFOs and tax leaders should review:

Existing settlement agreements

Internal R&D documentation procedures

Project-level recordkeeping

Credit calculation methodologies

Annual documentation policies

Waiting until an IRS examination begins often makes it difficult to reconstruct the evidence needed to support a claim.

Building Audit-Ready R&D Credit Claims

An effective R&D documentation process combines legal interpretation, technical evidence, and financial records. Businesses should establish systems that capture qualifying research activities throughout the year rather than relying solely on year-end interviews or estimates.

This proactive approach not only strengthens tax credit claims but also reduces examination risk and improves overall tax compliance.

Learn More About the Audio-Technica Decision

To better understand why settlement wording can significantly affect future R&D tax credit claims, read TaxDrone AI's detailed guide on why your R&D settlement documents must say exactly what you mean. The article explains the court's reasoning and provides practical guidance for businesses seeking to protect their tax positions.

Final Thoughts

Innovation is the driving force behind business growth. Companies invest significant resources in developing new products, improving manufacturing processes, building advanced software, and solving complex technical problems. To encourage this type of innovation, the U.S. government offers the Research & Development (R&D) Tax Credit a valuable incentive that helps businesses recover a portion of their research expenses.

However, claiming the R&D Tax Credit has become increasingly complex. In today's regulatory environment, innovation alone is no longer enough. Businesses must also demonstrate that every claimed activity and expense meets IRS requirements through well-organized, contemporaneous documentation.

Recent legal developments have reinforced this expectation, making it clear that documentation is now one of the most critical elements of a successful R&D tax credit claim. Tax professionals, CFOs, controllers, and business owners should understand how these changes affect their organizations.

For a detailed overview of these important developments, read The New Era of IRS Scrutiny: What Three Recent Rulings Mean for Your R&D Credits on TaxDrone AI:

👉 https://taxdrone.ai/blog/the-new-era-of-irs-scrutiny-what-three-recent-rulings-mean-for-your-rd-credits/

Understanding these evolving standards can help businesses strengthen compliance while protecting valuable tax savings.

The R&D Tax Credit Landscape Is Evolving

For many years, businesses focused primarily on identifying qualified research expenses and calculating the value of the available credit. While those steps remain important, the IRS now expects companies to provide detailed evidence supporting every aspect of their claim.

Today's R&D tax credit reviews often examine:

Technical uncertainty

Process of experimentation

Business components

Employee participation

Qualified Research Expenses (QREs)

Supporting technical documentation

Financial records

Project-level evidence

This shift means companies need a more structured approach to documentation than ever before.

Innovation Alone Doesn't Prove Eligibility

Many businesses assume that because they developed a new product or improved an existing process, they automatically qualify for the credit.

In reality, the IRS evaluates much more than the final outcome.

Businesses must demonstrate that they:

Faced technical uncertainty

Evaluated multiple potential solutions

Used a process of experimentation

Conducted qualified research activities

Properly documented the work

Without supporting evidence, even highly innovative projects may fail to satisfy IRS requirements.

Common Documentation Gaps That Create Problems

1. Missing Technical Records

Engineering teams often generate valuable documentation during product development but fail to preserve it for tax purposes.

Examples include:

Design specifications

CAD files

Source code repositories

Prototype revisions

Test reports

Validation records

These documents can play an important role during an IRS examination.

2. Weak Project Descriptions

Generic statements such as "developed new software" or "improved manufacturing" rarely explain the technical challenges involved.

Detailed project narratives describing uncertainty and experimentation are far more effective.

3. Poor Expense Tracking

Qualified Research Expenses should be supported by accurate payroll records, contractor invoices, supply costs, and project allocations.

Estimating expenses without documentation increases compliance risk.

4. Reconstructed Documentation

Waiting until tax season to recreate project information often results in incomplete or inconsistent evidence.

Maintaining documentation throughout the year is significantly more reliable.

Building an Audit-Ready Documentation Process

Organizations that consistently defend successful R&D tax credit claims typically establish standardized documentation procedures.

These often include:

Project Initiation Documentation

Record technical objectives, anticipated challenges, and expected outcomes before work begins.

Ongoing Project Updates

Maintain regular records of design changes, testing activities, technical decisions, and experimentation.

Employee Interviews

Capture detailed information about employee responsibilities, technical work, and project involvement.

Expense Documentation

Track wages, contractor costs, supplies, and project allocations as expenses occur.

Centralized Recordkeeping

Store engineering and financial documentation together in a secure, searchable system.

Why Technology Is Becoming Essential

Manual documentation processes often consume significant time and increase the likelihood of missing information.

Modern AI-powered solutions simplify compliance by helping businesses:

Collect documentation automatically

Organize engineering records

Match payroll data to qualified projects

Identify documentation gaps

Produce audit-ready reports

Improve collaboration between finance and engineering teams

Automation also reduces administrative workloads, allowing tax professionals to focus on strategic planning rather than manual record collection.

The Role of Finance Leaders

CFOs and finance teams play an increasingly important role in R&D tax credit compliance.

Their responsibilities extend beyond calculating the credit to overseeing documentation quality, internal controls, and audit readiness.

Finance leaders should:

Establish company-wide documentation standards

Coordinate with engineering departments

Review documentation regularly

Invest in compliance technology

Train employees on documentation expectations

Conduct periodic internal reviews

These practices strengthen claims while reducing potential audit issues.

Lessons Businesses Should Apply Today

Recent court decisions have made one message clear: documentation is no longer an afterthought.

Companies should:

Document research activities as they happen.

Preserve engineering records.

Standardize project reporting.

Maintain detailed payroll allocations.

Review documentation quarterly.

Prepare for audits before they occur.

Organizations that follow these practices are better positioned to maximize available tax credits while maintaining confidence during IRS reviews.

For more insights into how recent legal decisions are reshaping compliance expectations, read The New Era of IRS Scrutiny: What Three Recent Rulings Mean for Your R&D Credits:

👉 https://taxdrone.ai/blog/the-new-era-of-irs-scrutiny-what-three-recent-rulings-mean-for-your-rd-credits/

The article provides valuable guidance for businesses seeking to strengthen their R&D tax credit strategies.

Best Practices for Stronger Compliance

To improve long-term success with R&D tax credit claims, organizations should:

Create standardized documentation templates.

Review project documentation throughout the year.

Conduct employee interviews consistently.

Organize engineering and financial records together.

Track qualified research activities continuously.

Leverage AI-powered documentation tools.

Monitor changes in IRS guidance.

Educate technical teams about documentation requirements.

Perform annual internal compliance reviews.

Maintain records in a secure, searchable system.

Implementing these best practices helps businesses stay prepared for changing compliance expectations.

Final Thoughts

The R&D Tax Credit continues to provide meaningful financial support for businesses that invest in innovation. However, the standards for successfully claiming the credit are evolving.

Today's businesses must combine innovation with strong documentation, effective internal controls, and proactive compliance strategies. Organizations that invest in these areas will be better equipped to defend their claims, reduce audit risk, and maximize available tax incentives.

For defense contractors, aerospace engineering firms, and specialized software developers, the Research and Development Tax Credit is a vital mechanism for recouping massive capital investments. However, performing research on behalf of a third party or the federal government introduces a complex regulatory hurdle known as the funded research exclusion.

If the IRS determines that your research was funded by another entity, your business is disqualified from claiming the R&D credit for those specific projects. Understanding exactly where regulators draw the line is critical. The Federal Circuit Court of Appeals decision in Lockheed Martin Corporation v. United States remains the definitive legal precedent for navigating these high risk contract disputes.

The Two Prongs of Funded Research

Under Section 41 of the Internal Revenue Code, research is considered funded, and therefore ineligible for the credit, unless the taxpayer meets two distinct criteria.

First, the taxpayer must bear the economic risk of loss if the research fails. This is typically established through fixed price contracts where payment is contingent upon delivering a successful product.

Second, the taxpayer must retain substantial rights to the results of the research. In the Lockheed Martin case, the IRS conceded that the company bore the economic risk under its government contracts. The entire legal battle hinged on the substantial rights requirement. The IRS argued that because the government retained unlimited rights to use the technical data and patents, Lockheed Martin did not possess substantial rights to its own research.

The Substantial Rights Breakthrough

The court firmly rejected the regulatory argument, delivering a massive victory for contractors. The ruling established that a taxpayer does not need exclusive control over the research results to satisfy the statutory requirement.

According to the Federal Circuit, retaining substantial rights simply means the taxpayer retains the legal ability to use the research results in their own business operations without being forced to pay a third party for that privilege. The fact that the federal government also had unlimited access to the data did not negate the contractor's right to commercialize the underlying technology.

Contract Structuring for Modern Innovators

This ruling has profound implications for any business engaging in contract based research. If your company designs custom manufacturing equipment, develops proprietary software for enterprise clients, or acts as a government subcontractor, the language in your master service agreements dictates your tax liability.

To protect your R&D credits, your contracts must explicitly state that your firm retains the right to use the knowledge, techniques, and underlying technology developed during the project. If a contract requires you to transfer all intellectual property and completely bars you from using the research methodologies in future projects, the IRS will classify the work as funded research.

Protecting Your Corporate Tax Strategy

Relying on outdated or poorly structured contracts is one of the most common reasons companies lose millions of dollars during an IRS audit. Corporate leaders must proactively align their legal agreements with current tax court precedents.

To gain a deeper understanding of the specific contractual clauses analyzed in this landmark ruling, read the complete case breakdown in Lockheed Martin v. United States: What It Means for Your R&D Tax Credit.

If your company builds custom software, designs specialized hardware, or engineers bespoke technical solutions for clients, you are likely sitting on a goldmine of R&D tax credits. Every dollar spent on engineering wages, prototyping, and testing should theoretically be clawed back to fuel your growth.

But there is a hidden legal tripwire in the tax code that quietly disqualifies thousands of custom developers every single year. It is called the Funded Research Exclusion.

The IRS frequently uses this rule to argue that if a client is paying you to develop a product, they get the tax credit, not you. According to the agency, your work is fully "funded" by a third party, wiping your qualified research expenses off the table completely.

To win this fight and protect your capital, your finance and engineering teams must master the landmark legal framework established in Lockheed Martin Corp. v. United States.

The Federal Circuit's ruling in this multi-million dollar dispute created the definitive playbook for who gets to claim the credit when code or technology is built under contract. If you don't structure your client agreements around this precedent, you are leaving six figures on the table.

Here are the two non-negotiable standards your contracts must meet to survive an IRS audit.

1. The Financial Risk Standard (Who Pays If It Fails?)

The first major hurdle in a contract dispute is determining who bears the economic risk of the technical development.

The IRS looks closely at how you get paid. If you sign a standard "Time and Materials" or "Cost-Plus" contract where the client pays for every hour your engineers work regardless of the final outcome, the client holds the financial risk. In that scenario, your research is considered funded, and you cannot claim the credit.

However, if you operate under a Fixed-Price contract or a milestone-based agreement where payment is strictly contingent on the success of the research, the risk flips to you. If your team runs into a technical dead-end, hits a software bug, or fails to deliver the promised specifications, you must fix it on your own dime or risk getting nothing.

Because you bear the cost of failure, you own the financial risk required to qualify for the R&D credit.

2. The Substantial Rights Standard (Who Owns the Know-How?)

This is where the Lockheed Martin case completely reshaped the landscape for modern tech companies.

The IRS long argued that if a contractor creates intellectual property for a client or the government, and that client has the right to use the data, the contractor loses their R&D tax rights.

The court flatly rejected this logic. They ruled that exclusivity is not required to claim the credit. Even if your client owns the final software code, the master blueprints, or the patent rights, you can still claim the R&D credit as long as you retain substantial rights to the underlying research results.

What does that mean in plain English? If your engineering team can take the core technical methodologies, libraries, or architectural lessons learned during the project and freely apply them to other areas of your business without paying a license or royalty fee to your client, you have retained substantial rights.

Bulletproofing Your Client Contracts

The overarching takeaway from Lockheed Martin is that the IRS determines R&D eligibility by looking at your legal contracts, not just your engineering logs.

If your contracts are filled with generic boilerplate language that blindly signs away all rights and guarantees payment regardless of product performance, you are actively forfeiting your tax incentives. Modern technical compliance requires a unified strategy where your legal language matches your financial goals.

If you want to protect your innovation incentives and learn exactly how to audit your active master service agreements (MSAs) for risk and rights, you need to dive into the core mechanics of the ruling.

Companies frequently miss out on lucrative Research and Development tax credits due to anxiety over their client contracts. A widespread misconception in the tax and engineering sectors is that a contract must explicitly contain the words "R&D" or "Research" to avoid the dreaded funded research exclusion.

The recent ruling involving System Technologies proves that the courts look at the actual economic substance of an agreement rather than demanding magic words.

The Internal Revenue Service routinely challenges R&D claims by arguing that the taxpayer’s client actually funded the research. To survive this scrutiny under IRC Section 41, a taxpayer must prove two distinct elements. First, they must bear the economic risk of the development. Second, they must retain substantial rights to the research results.

Here is how the System Technologies case redefines how those two requirements are interpreted.

Economic Risk Resides in the Delivery Terms

In the System Technologies case, the government argued that the company’s contracts did not explicitly allocate R&D risk. The court rejected this rigid interpretation. Instead, the court examined the payment structures within the agreements.

The ruling affirmed that because System Technologies operated under fixed price terms where payment was entirely contingent on delivering a functional end product, the company inherently bore the economic risk of failure. If the technological development failed, the company would not be paid for its time or materials. The lack of specific "R&D risk" terminology did not override the fundamental financial reality of the contract.

Retaining Substantial Rights Without Specific IP Clauses

The second major hurdle in the funded research test is the retention of intellectual property rights. Many businesses assume that standard vendor contracts automatically strip away their R&D eligibility because they lack dedicated clauses protecting the vendor's IP.

The court in the System Technologies case offered a more pragmatic view. Even without explicit language reserving intellectual property for the taxpayer, the court found that the company retained the practical right to reuse the baseline software architecture and engineering methods it developed. Delivering a custom piece of software to a client does not inherently surrender the developer's right to utilize the underlying technical knowledge on future projects.

Strategic Takeaways for Service Providers

While businesses should always strive to optimize their Master Service Agreements for clear tax compliance, this ruling provides significant relief. A lack of precise R&D terminology is not an automatic disqualifier for the Section 41 credit.

Companies conducting custom engineering, software development, or architectural design should conduct a thorough review of their historical contracts. The economic substance of those agreements might already provide the protection needed to claim substantial tax refunds.

When modern companies claim the Research and Development tax credit, they usually rely on sophisticated project management software and automated time tracking to substantiate their Qualified Research Expenses (QREs). But what happens when contemporaneous time records are missing or incomplete?

Tax professionals and IRS examiners frequently point back to a landmark 1994 ruling: Fudim v. Commissioner (T.C. Memo 1994-235).

Despite being decades old, this case remains one of the most cited precedents regarding how employee time can be allocated to qualified research activities when perfect daily logs do not exist. It established the critical role of the Subject Matter Expert (SME) in surviving an IRS audit.

Here is a breakdown of the Fudim ruling, why the Tax Court allowed the taxpayer to estimate their R&D time, and what modern financial leaders must learn from it.

The Case: Rapid Modeling and Missing Records

In the 1980s, Efrem Fudim formed Light Sculpting Co. and developed an innovative rapid modeling process utilizing ultraviolet light and liquid polymers to create 3D plastic objects. When he claimed R&D tax credits for 1986 through 1988, his QREs were based heavily on supplies and the wages paid to himself, his wife, and his daughter.

The problem was that the company did not maintain extensive written records of the exact hours spent on research. Instead, Fudim relied on time percentage estimates to determine the qualified research activities.

Historically, the IRS heavily scrutinizes estimated time. In this case, the IRS disallowed portions of the credit, forcing the Fudims to petition the Tax Court.

The Ruling: The Power of Subject Matter Expertise

In a massive victory for the taxpayer, the Tax Court ruled that Fudim and his wife were engaged in qualified research activities and accepted their time allocation estimates. The court determined they spent more than 80 percent of their time on research, allowing them to claim the full "substantially all" threshold for their wages.

Why did the court accept estimates without daily time logs? The decision came down to two factors: SME credibility and corroborating technical evidence.

First, Fudim possessed exceptional credibility as a Subject Matter Expert. He held a doctorate from the Institute of Control Sciences of the U.S.S.R. Academy of Sciences, and his wife held a mechanical engineering degree. Fudim had direct, firsthand knowledge of the research activities being conducted.

Second, the estimates were backed by objective, corroborating proof of innovation. Fudim produced contemporaneous scientific articles describing his process and, most importantly, evidence of two patents he was awarded for his rapid modeling technology. The patents proved the technical uncertainty and the process of experimentation actually occurred.

The Warning: Why the Daughter's Wages Were Denied

While the court sided with Fudim and his wife, they completely disallowed the QREs claimed for the wages paid to their daughter.

The submissions to the court failed to establish her technical background, her specific training, or the exact nature of the services she provided. The court ruled that without sufficient evidence proving her direct involvement in technical research, her estimated time was invalid.

3 Modern Lessons for CFOs and Tax Directors

While the Fudim ruling allows for time estimation under specific conditions, the IRS has become significantly stricter in recent years. Modern companies must apply these three lessons to protect their R&D credits.

1. Rely Only on Credible SMEs for Time Allocations

If you must allocate time retroactively or estimate percentages, the person providing the allocation must have direct, firsthand knowledge of the technical work. The IRS will quickly reject allocations made by accounting departments, executives without technical backgrounds, or outside consultants. The allocations must come from the engineers or project leads who actually supervised the work.

2. Patents and Corroborating Evidence Save Claims

If your time tracking is weak, your physical evidence must be overwhelming. The Fudim case proves that patents, technical schematics, test logs, and scientific publications serve as powerful corroborating evidence that the statutory process of experimentation took place.

3. Establish a Clear Nexus

You cannot claim blanket percentages across an entire department. You must establish a clear nexus between the specific employee, their technical qualifications, and the exact qualified activity they performed. Failing to define an employee's technical role will result in disallowed wages.

Bulletproof Your R&D Tax Strategy

While Fudim v. Commissioner provides a safety net for companies with imperfect time tracking, intentionally relying on estimation is a massive financial risk in today's audit environment.

For technology and manufacturing CFOs, the federal Research and Development (R&D) Tax Credit under IRC §41 is a powerful tool to offset payroll tax liabilities and infuse working capital back into the business. But claiming the credit is only half the battle; defending it is where many companies fall short.

If your organization is relying on retrospective estimates or manual spreadsheets to support your R&D claims, you might be exposing your company to disallowances and penalties. To understand why, we need to look at a landmark Tax Court decision: Union Carbide Corp. v. Commissioner.

The $200 Million Cautionary Tale In this pivotal case, a major multinational corporation lost a substantial portion of its claimed R&D credits. The IRS heavily scrutinized the claim, and the Tax Court ultimately sided with the Commissioner, citing two major deficiencies: improper treatment of supply costs and a failure to prove a "process of experimentation."

While this case is historical, its implications are active and urgent today. As detailed in the original breakdown, The $200M R&D Lesson: Deconstructing Union Carbide Corp v. Commissioner, the IRS continues to reference this decision during examinations.

Where Do Companies Go Wrong?

Misallocating Supply Costs: Union Carbide attempted to claim the costs of raw materials used during experimental production runs. However, the court ruled that simply consuming materials during an experimental run isn't enough. Taxpayers must prove those materials were used primarily in qualified research, completely separate from routine commercial production.

Failing the "Process of Experimentation" Test: IRC §41 requires that substantially all activities in a research project follow a systematic process of experimentation intended to eliminate technical uncertainty. Without contemporaneous documentation showing hypotheses, testing, evaluation, and refinement, the IRS will likely view the activities as routine adjustments rather than qualified research.

Modernizing Your R&D Credit Strategy The key takeaway for finance leaders is clear: intent does not equal compliance. To build defensible R&D credit claims, companies must abandon manual, after-the-fact estimation in favor of technology-assisted approaches.